Lihir a millstone for Newcrest

Until this week,
Newcrest Mining
had faced very little criticism over its $10 billion takeover of
Lihir Gold
. It was, after all, the deal many believed needed to be done to create a genuine Australian gold champion with the scale and investment appeal to compete with the world’s biggest.

But the spotlight has swung to whether Lihir’s main asset, its namesake mine in Papua New Guinea, is generating an acceptable rate of return, and more importantly, whether it will in the future.

Merrill Lynch analyst Stephen Gorenstein explored the topic thoroughly in a research note published on Monday, although his peers have no doubt also considered it at length in their work on the country’s largest goldminer.

One of Gorenstein’s conclusions was that the return on equity from Lihir is substandard.

Last financial year the PNG mine produced a return of 6 per cent, the worst of Newcrest’s four mainstay operations. By comparison, the Gosowong mine in Indonesia returned 117 per cent, Cadia Valley in New South Wales 17 per cent and Telfer in Western Australia 12 per cent. Consequently, Lihir dragged the company’s average return on equity down to 11 per cent.

But this is a long way from suggesting that the takeover can, or should, be labelled a failure.

Gorenstein says the key to improving returns from the Lihir asset is increasing production to a level more suitable for a resource of its size, which is what Newcrest is in the process of doing.

There is a recognised bottleneck at Lihir in processing. Under the million ounce plant upgrade – a project expected to cost $600-700 million – Newcrest is expanding processing capacity from 6 million tonnes a year to 10.5 million to 12.5 million tonnes a year.

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The MOPU is scheduled to be completed in the December quarter next year, and should increase production to 1.2 million to 1.3 million ounces of gold a year. Further optimisation of the plant could lift annual output to 1.4-1.5 million ounces, a target Newcrest is aiming to hit in financial year 2016.

Based on his back-of-the-envelope calculation, Gorenstein believes the expansion should transform Lihir into one of the company’s better returning operations.

On the base case of 1.2-1.3 million ounces a year, he estimates return on equity rising to 16 per cent by financial year 2020. With the 1.4-1.5 million ounce rate, it should rise to21 per cent.

The increase in processing capacity at Lihir should also help Newcrest to drive costs down, although Gorenstein doesn’t believe reducing costs is as important as lifting production as far as improving returns goes.

He identifies the Lihir acquisition as the “watershed moment" in terms of a notable rise in the company’s site unit costs (which include mining, milling and general and administrative costs). In the past 18 months, these have jumped from $22 a tonne to $42 a tonne.

“While there are a number of reasons for this (escalating industry costs, reduced by-product revenue and a strong Australian dollar, to name a few), we feel one of the key causes of this is the Lihir acquisition," he says.

“We believe the fundamental problem at Lihir is too much mining and not enough processing." Gorenstein’s figures Lihir has added $5 to $6 a tonne to Newcrest’s site unit costs, while other factors have contributed to the rest of the increase.

Newcrest’s management incentive scheme is strongly linked to shareholder returns, and while it is calculated for the company as a whole, separating out Lihir – as Gorenstein has done – produces some interesting results.

The long-term incentive plan is equally weighted based on the performance of comparative cost position, reserve growth and return on capital employed.

If management was being judged on Lihir alone, they would qualify for none of their bonus on the ROCE measure, 80 per cent on the comparative cost measure and somewhere between 9 and 24 per cent on the reserve growth measure.